Will debt mutual funds lose sheen sans tax benefits?

Are debt mutual funds still attractive after the withdrawal of LTCG tax benefits from the new Financial Year?

- VR Naidu, Guntakal

Debt mutual funds are those funds whose portfolio's debt exposure is more than 65 per cent of the corpus and equity exposure is less than or equal to 35 per cent. Debt mutual funds invest 65 per cent in debt instruments like certificates of deposits, debentures, bond papers, etc. From FY 2023-24, capital gains made on debt funds, ETFs, gold funds, international funds, and some hybrid funds will no longer receive indexation benefits and are deemed short-term capital gains.

As global funds, gold funds also invest less than 35 per cent in domestic equities; the capital gains made on these funds will also be treated like debt funds' tax treatment. In other words, capital gains made on mutual fund schemes or ETFs that invest up to 35 per cent in domestic companies or exposure to Indian equities will be added to the investor's income and taxed as per the investors' income tax slab rate. Investors will have to forget and forgo the LTCG (long-term capital gains) tax and indexation benefits of debt mutual funds.

Till the financial year 2022-23, any capital gain made on redemption of a debt fund held for three years or longer is considered a long-term capital gain and taxed at a flat 20 per cent after indexation. Till the last financial year, investors in debt funds were paying tax on capital gains according to their income tax bracket for the first three years of holding, after which they were taxed at 20 per cent with indexation advantages or 10 per cent without indexation. This taxation will be effective from 1 April 2023. To reiterate, only those debt mutual funds where equity investments do not exceed 35 per cent will lose LTCG tax benefits. Debt mutual funds will lose the sheen after the indexation benefit is removed from 1 April 2023. The reason is that the earnings from debt mutual funds held for fewer than three years or more will now be added to the investors' taxable income. This means the rate of gains from debt mutual funds will become at par or equal to fixed deposits. Hence, the removal of long-term capital gains benefits and indexation has made debt funds an unattractive investment option for long-term investors, especially those in the higher tax brackets compared to bank fixed deposits and bonds. The gap in returns between various debt instruments would be narrowed or eliminated, which would benefit bank fixed deposits.

Gold funds may be getting less glittery after 1 April 2023 as gains from investments in gold funds will be taxed at the slab rate of the investor, irrespective of the holding period. However, Sovereign Gold Bonds (SGBs) are set to shine brighter after 31 March 2023. Investing in gold in the form of SGBs looks more tax-friendly than putting the money in the gold funds or gold ETFs. SGBs offer tax-free returns, but the lock-in period is five years, and the maturity is eight years. On the other hand, Gold funds are highly liquid.

One can invest in AIFs (Alternative Investment Funds), as AIFs are tax efficient with better returns than debt mutual funds. Investments of AIFs comprise hedge funds, venture capital funds, and private equity funds. Hence AIFs carry higher risks than debt mutual funds. In terms of liquidity, debt funds beat AIFs.

Irrespective of the tax treatment, debt funds are a must for every portfolio as these funds help investors to spread across instruments and reduce risks. Diversification or spreading the investments is important and must limit the exposure to any one type of asset in the portfolio. Debt funds and gold funds are flexible and can be redeemed partially. In the case of fixed deposits, partial withdrawal of fixed deposits is not allowed via net banking. One has to visit the bank with a withdrawal form. Also, premature liquidation of fixed deposits before maturity usually attracts a heavy penalty. Bank Fixed deposits become unattractive when interest rates fall. Debt mutual funds deliver higher returns when the interest rates fall because the prices of fixed-rate bonds increase.

To conclude, fixed deposits, bonds, equities, equity mutual funds, sovereign gold bonds, and alternative investment funds are poised to gain at the expense of debt mutual funds, gold funds, international funds etc whose equity investments in domestic stocks do not exceed 35 per cent. Before shifting investments or making a decision, the investors must assess the risk-reward ratio. One may consult a financial advisor or CFP for a better investment strategy and personalised and customised advisory.